Investment Banking

THE INVESTMENT BANKING INDUSTRY:

Investment Banks (IB’s) are financial intermediary institutions that play a critical role in the capital market, by supporting the entities on rising capital both in the form of equity or debt. Another key area of action of IB´s has been providing assistance in Merger & Acquisition (M&As) processes. Other activities are also conducted by these institutions including brokerage, derivatives and equity securities trading, market making and financial advisory. All the trading and underwriting related activities are part of the called Sell Side being the advisory and assistance services included in the Buy Side of the business. These activities are divided according to their nature in Front Office, Middle Office and Back Office.

Front Office covers the revenue generating activities, namely “Investment Banking” (securities underwriting and M&As), Sales & Trading and Research. Because they also obtain revenues from trading financial instruments with their own money, they must ensure the total independence of their different divisions (advisory and trading) to avoid conflict of interests. Such dependence is kept by the commonly called “Chinese Wall”, being an ethical barrier preventing any possible conflict of interest due to information leakage that could be used to obtain benefits in proprietary trading or for other customers.

Middle Office involves activities such as risk management, financial control and compliance, treasury and strategy. These control related activities on the transactions conducted by Front Office, and are crucial to keep the business within the reasonable level of risk (market related risk), protecting the company stability.

Lastly, the Back Office comprises of the operational side and all technology Related responsibilities. While Front Office negotiates and makes deals, back office is responsible to ensure the transactions are executed successfully .

The industry evolution

Having its origin in the 19th century, the industry has undergone through several ups and downs with successes and crises followed by regulatory actions aimed at protecting the investor interest and the health of the sector. Some relevant acts worth mentioning, dated in the first half of the 20th century are the Security Act of 1933 (disclosure of all relevant information in security issues), Glass-Steagall Act of 1933 (Separating Commercial and Investment banking) and the Security & Exchange Act of 1934 (Setting Financing & Governance Procedures).

Later in the 1970’s, important changes began in US market following the going public of most firms, the collapse of Bretton Woods system, the volatility of the market created after the rising of OPEC, the Employee Retirement Income Security Act of 1974 (Prudent Man Rule) and the Repeal Of Fixed Commissions in 1975.

Changes continued in the 80´s in US and in the international capital market with the adoption of the Shelf Registration Rule (1982) and the numerous M&As. More recently in the 90’s, the IB industry enjoyed a golden era signed by the issuance of $15 trillion in securities, $10 trillions in M&As, the emergence of the Euro and the globalization of the industry. The wave of privatizations in US, the rising of the pension funds and sector deregulation were factors that fuelled the growth of the business.

The growth of the international market brought volatility as the industry was susceptible to the risks caused by crises such as the Mexican Devaluation (1994), The Asian Economic Crisis (1997) and the Russian Default in 1998 that contributed to the fall of LTCM. Looking at the evolution and trend of the IB´s industry, many analysts have categorized the sector as one signed by a short memory, at that is evidenced by the quick recovery and survival after the 1998 crisis with the significant rising of Euro-denominated securities and Internet IPOs.

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